Small Business Tax Incentives: 3 Programs Every Startup Should Know
Tax season may seem in the distant past. However, since Congress passed three major stimulus bills in the last 12 months, all of them containing significant tax incentive opportunities for small- and middle-market businesses, tax planning can be more impactful for business owners than ever.
The rules may seem nuanced and confusing, but, properly applied, the economics can be game-changing. Several acronyms related to these programs have been in the news the past few weeks: PPP, WOTC, ERTC, and R&D. But how many people know what they are and how they can help? There may be a wealth of incentives available to them and they don’t even know it.
Historically, participation in tax incentive programs has been limited to large corporations. But with Congress’ efforts over the last 10 years generally, and the last 12 months specifically, privately held businesses can benefit from these programs in a way that was not previously possible. As with every new administration, there are often changes to tax incentive programs that support businesses in good times and in bad. No matter the leadership, the federal government has always leveraged incentive programs to encourage businesses to invest in infrastructure, jobs, and new products within their jurisdiction. In the past, the structure has skewed access dramatically toward large businesses, but that is changing. Over the past year, the tables have turned meaningfully toward smaller businesses.
Because of the mass effects of the COVID-19 pandemic on nearly every industry, the government broadened the accessibility of incentive programs to support more employers on a broader scale in 2020 and will be providing even more assistance in 2021. A few months ago, President Joe Biden signed the American Rescue Plan (a $1.92 trillion coronavirus relief bill) into law. Here are a few examples of the programs that may be available.
Research and Development Tax Credit (R&D)
As Biden turns his attention toward an infrastructure bill, there is now a proposal in Congress to extend eligibility for the R&D credit for qualified startups from five years to right years, as well as expand the credit that can be claimed against a company’s payroll taxes from $250,000 to $500,000 each year.
Generally, large companies account for the largest portion of R&D credit dollars claimed each year. Yet it’s important to note that the R&D tax credit isn’t just for large companies with established R&D departments. Any company that develops new or improved products, processes, or software may qualify under the US tax code–whether developed successfully or not.
Ways to Use the R&D Tax Credit
- Income taxes if you are in a taxable position.
- Alternative Minimum Tax (AMT) if you have average annual gross receipts for the prior three years of $50 million or less, and you owe AMT in the current year.
- Employer portion of Social Security taxes up to $250,000 for each fiscal year if you are a qualified small business. This payroll tax offset allows qualified small businesses to receive a benefit for their research activities regardless of profitability.
Regardless of industry, size, or revenue, any business that performs activities meeting the following four tests qualifies for the R&D tax credit.
The 4 Tests to Pass to Use the R&D Tax Credit
- Permitted Purpose: the purpose of a qualifying project must be related to creating a new or improving an existing business component.
- Technological in Nature: work needs to rely on principles of physical, biological, or computer science or engineering.
- Elimination of Uncertainty: when work on a qualifying project began there would have been uncertainty related to your capability to create the product or improvement, the methodology you would use, or the correct product design.
- Process of Experimentation: the project must involve a process by which you tested alternatives and resolved the uncertainty above.
Employee Retention Tax Credit (ERTC)
Who is eligible for the ERTC? More businesses than you might think. There are three ways to qualify for the ERTC.
The 3 Ways to Qualify for the ERTC
- Significant decline in quarterly gross receipts: 20 percent or more decline in 2021; 50 percent or more decline in 2020.
- Full or partial government shutdown hindering more than a nominal portion of operations; also consider key vendors.
- Recovery startup for starting a new trade or business after February 15, 2020, with average annual revenue < $1 million.
A business is eligible if it had to fully or partially suspend operations during any calendar quarter in 2020 due to orders from a governmental authority limiting commerce, travel, or group meetings due to COVID-19, or if they experienced a significant decline in gross receipts during any calendar quarter relative to the same calendar quarter in 2019. This means a lot of businesses are eligible (think restaurant, retail, healthcare, staffing, gyms, etc.).
In 2021, the Employee Retention Tax Credit was increased to 70 percent of qualified wages that are paid to employees with a maximum credit of $7,000 per employee per quarter.
There are significant limitations on what constitutes qualified wages for large employers (more than 100 full-time employees in 2020 and more than 500 full-time employees in 2021), which makes this program significantly more lucrative for smaller businesses.
And to encourage small businesses to innovate, Congress expanded the ERTC for companies that have recently started a new trade or business and those that will do so before the end of 2021. For the last two quarters of 2021, any business that has average gross receipts of less than $1,000,000 for the previous three years can become eligible for the credit just by starting a new trade or business and earn up to $100,000 before the end of 2021. By definition, a “new trade or business” can be an entirely new company, or it can be a new trade, product, or service offering within an existing business.
Paycheck Protection Program (PPP)
This is one you’ve likely heard of already, as it was discussed at length last year when the pandemic hit. The government is offering a second round of PPP to employers with less than 300 employees that previously received a PPP loan if they can show that they experienced a reduction in gross receipts of at least 25 percent between comparable quarters in 2019 and 2020.
Eligible expenses have also been expanded to include a number of new expenses, including worker protection costs, certain supplier costs, and operating expenses. This second time around, the maximum loan amount has increased for accommodation and food services businesses.
Perhaps the most exciting news about this second round of PPP is that employers don’t have to choose between PPP and the Employee Retention Tax Credit. Now, both programs are available to eligible employers. There is also an opportunity to go back and claim money from 2020 retroactively.
Like all tax incentives, these programs are optional. However, it is necessary to note that the increased taxes likely to result from the amount spent on stimulus programs over the last 12 months will not be optional. So it behooves small businesses to look into these programs and optimize them if they are eligible. Essentially, they’re going to get their share of the bill later, so they might as well get their share of the meal now.
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Each of these federal incentive programs has meaningful eligibility and computational requirements that require some thought to optimize. For example, a business cannot claim ERTC and R&D tax credits for the same wages. However, given the potential gains to be made, optimizing the programs is critically important. For them to optimize these programs, they must make a plan to leverage them. This likely involves working with a CPA and a tax attorney, and possibly even a dedicated platform to simplify the tax incentive process. This process isn’t signed and sealed; there will still likely be changes and supplemental programs rolling out throughout the remainder of the year and into 2022. It is critical for businesses to stay informed with the changing landscape so they’re ready to take advantage of the many ways they can be supported.